Market Economics | Interest Rate Strategy - BNP PARIBAS ...

The latest developments increase the probability of
the opposite outcome: i.e. that the refinancing rate
could be raised before the tender procedures have
been returned to 'normal': i.e. before competitive
bidding is implemented across all operations.
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Chart 1: Cost Pressures Contained
Hourly Labour Costs (% y/y)
To be fair, the ECB has kept its options very much
open throughout the debate about its exit from policy
stimulus and Mr Trichet was very explicit in the press
conference that either order was possible.
Running late
Our own forecast has been for the ECB to deliver its
conventional tightening 'late': i.e. the first increase in
the refinancing rate would be delivered only in Q2
2012. This forecast has been predicated primarily on
low core inflation at the eurozone aggregate level,
solid but unspectacular eurozone growth given
substantial fiscal headwinds in some member states
and unusually low money and bank lending growth
rates. Ongoing market turbulence and uncertainty
over the outlook for sovereign debt markets has also
been a key element of our forecast of the tightening
cycle beginning next year not this.
Nonetheless, we have highlighted that pay trends in
the core of the eurozone, in Germany especially,
were likely to be a source of concern for the ECB this
year. As such, while we did not forecast that the ECB
would actually be hiking rates in 2011, we expected
the debate in the market (and on the ECB Governing
Council) to be in the direction of ‘early’ tightening.
This debate is obviously up and running now and if
our expectation of macroeconomic developments in
the next few months – an acceleration in ‘hard’
activity data to follow the buoyant sentiment surveys,
and above-target inflation - is borne out, the market
will continue to price in an increasing probability of
rate hikes this year.
Progress at the finance ministers meeting at the start
of next week towards expanding and/or evolving the
EFSF would further reinforce that trend as it would
reduce the likelihood of another bout of extreme
stress in sovereign markets, removing one potential
obstacle to future ECB tightening.
Inflation developments
Whether the ECB's bark will ultimately prove to be
worse than its bite will depend on a range of factors.
But the key issue, on the basis of what we heard
from the press conference, is whether the elevation
of headline inflation continues and leads to higher
inflation expectations and/or 'second round' effects
on wages which drive core inflation higher. Wage
trends remain low by past standards (Chart 1). But
surveys of household price perceptions have been
shifting upwards (Chart 2).
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Negotiated Wages (% y/y)
Compensation per Employee (% y/y)
97 98 99 00 01 02 03 04 05 06 07 08 09 10
Source: Reuters EcoWin Pro
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70
60
50
40
30
20
10
0
-10
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Chart 2: Price Perceptions Increasing
EC Consumer Survey:
Price Trends
86 88 90 92 94 96 98 00 02 04 06 08 10
Source: Reuters EcoWin Pro
Past 12 Months
Next 12 Months
Our expectation is that a combination of favourable
base effects and a moderation in oil prices will lead
to a deceleration in headline inflation from March
onwards, with the rate going back below 2% from
April. The anxiety at the ECB over inflation should
recede if so. We also expect the fiscal difficulties in
the eurozone to remain a problem for some time yet
and an intensification of volatility in markets could
quickly move the focus of the ECB’s agenda away
from policy tightening.
Bottom line
The ECB has given the market, and forecasters, a
wake up call, highlighting its increasing unease over
inflation and making it clear that higher interest rates
will be delivered if prospects continue to deteriorate.
The chances of the conventional exit being delivered
earlier than the unconventional exit have also risen.
While our own forecast remains for a ‘late’ tightening,
the risk of earlier hikes has clearly risen. The signals
from the ECB also reinforce our view that it will hike
before the Fed does. As relatively little in the way of
rate hikes has been priced in for this year, the market
is likely to continue to shift in the direction of early
tightening absent a resurgence in market volatility.
Ken Wattret 13 January 2010
Market Mover
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